Why You Should Care About the Volcker Rule

Some argue that it could prevent another financial crisis.

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The dense, complex Dodd-Frank provision gets at larger issues of government intervention and systemic risk.

All eyes in the financial world turned to Capitol Hill Wednesday to watch lawmakers wrangle over n market-making, BASEL III, proprietary trading and liquidity management. The discussion, involving two subcommittees of the House Financial Services Committee, discussed the Volcker Rule, a proposal that is part of the Dodd-Frank Financial Reform Bill.

While the particulars are convoluted and the terminology is dense, Americans outside the realm of high-frequency traders and hedge fund owners have a stake in Wednesday's hearing.

Simply put, the Volcker Rule would prevent FDIC-backed financial institutions from engaging in proprietary trading. To simplify it even more, that would limit large, insured banks from making risky investments and potentially threatening the broader financial system.

Wednesday was full of economic experts arguing for and against the Volcker rule. Here are three reasons why everyone should pay attention to what was said:

[See our exclusive interview with Richard Cordray.]

The rule may help the country avert another financial crisis.

There is plenty of debate as to proprietary trading's role in causing the meltdown, but at the very least, it didn't help matters, as firms lost capital on risky investments, which helped reduce the credit available in the broader U.S. economy.

Some argue that allowing federally backed institutions to continue to make these investments allows them to see potential gains that far outweigh their potential risks."When things go well, the benefits of these arrangements are garnered by the executives who run these firms (and perhaps shareholders). When things go badly, the downside costs are pushed in various ways onto the taxpayers and all citizens," Simon Johnson, professor of entrepreneurship at MIT Sloan School of Management, told members of the Financial Services Committee..

In addition, Dodd-Frank identifies some large firms as "systemically important financial institutions." According to Kent Smetters, professor of business and public policy at the Unversity of Pennsylvania's Wharton School, this once again calls to mind a big problem that became evident in the financial crisis: "Essentially, most people read [the phrase "systemically important"] as the government still having their back. So allowing those people to trade their own personal book, knowing that the government has their back... that strikes me as a big moral hazard problem. That's not a good thing to have happen," says Smetters.

The rule has been gutted, and the changes help the banks.

The rule has been bloated to hundreds of pages, but they contain numerous exemptions to the proprietary trading ban. As the New York Times' James Stewart reported last October, finanical institutions have worked to "water down" the initial 10-page-long rule, and are now arguing that it's too complicated to follow. As Fidelity Investments Head of Global Bond Trading Alexander Marx told the congressional panel, U.S. banks would be "forced to devote significant resources in their efforts to comply with the Volcker Proposal," and that compliance would put them at a disadvantage to foreign firms.

In other words, the fight over the Volcker Rule is, in some ways, an example of large financial institutions trying to continue the behavior that some say contributed to a financial meltdown in the first place.

[Read about the new debt ceiling vote.]

Is the rule nothing more than piece of extended government regulation?

The Volcker Rule can also be seen as the government unnecessarily intruding into a private marketplace, says Brian Gardner, senior vice president of Washington Research at financial services firm Keefe, Bruyette and Woods.

"What is the criteria by which we have decided that private firms that derive no great benefit from the government, certainly no direct benefit from the government, should be limited in their ability to take risk?," Gardner asks. He adds that at a certain point, government regulation of proprietary trading becomes a slippery slope. "At what point does the government then step in and start regulating the amount of risk that hedge funds can take? These are questions that you cannot answer." Gardner believes that the current legislation has not adequately addressed those questions.